Gravity Pulls on The Cartoon Euro

You know those cartoon characters that run off the edge of a cliff and run furiously in the air before starting to fall?

That’s rather like the euro right now.

AFP/Getty Images

The currency has held bizarrely, bafflingly firm against the dollar of late, with market-watchers scratching their heads in search of a reason.

Meanwhile, the euro-zone government bond markets have continued to implode, just as they have been doing for months.

Not so long ago, the two markets moved in sync. As investors got jittery about default risks, pushing out bond yield spreads and ramping up the cost of insuring against sovereign defaults, the euro fell. Ebbs and flows in the bond markets led to mirror-image movements in the currency.

Quite abruptly, though, that relationship broke down recently, with the euro running higher against the dollar after sinking to a four-year low at the start of June. From that point, the 16-country currency leapt some 5% higher, to almost $1.25 by June 21. It’s still not far from there now.

The closing of successful negative bets on the euro appears to be one reason. But it will get you only so far, as that’s one chunky short-squeeze. The lack of significantly worse news on the euro zone appears to have helped.

Conspiracy theorists also point to the invisible hand of China acting to weaken the dollar as part of its own currency-management program. In particular, it’s worth noting that the euro has continued to come under selling pressure against sterling, Nordic currencies, and especially the sky-high Swiss franc, so the climb against the dollar is a weird outlier. Whether the conspiracy theory holds water or not, and it’s impossible to prove or disprove, the euro-zone debt crisis had not turned a corner, so the rally has left most analysts stumped.

Meanwhile, in the bond markets, crisis mode prevails. Greek credit default swaps now trade at roughly the same level as equivalent Icelandic contracts did immediately before that country went belly-up. It’s now more expensive to insure against a Greek default than a default by Argentina. It’s only a little bit cheaper than insuring against a Venezuelan default. Gulp.

The doom check-list continues.

Spanish default insurance is still around the highs seen in early May–the point seen by many as the high point of the euro-zone debt crisis.

Looking at its own customer flows, The Bank of New York Mellon reckons that outflows from Greek and Italian debt are still in full swing. Worryingly, outflows from French debt are also stubbornly persistent. The gap in yields between German (ie safe) and Portuguese (ie not so safe) 10-year bonds stands close to early May levels.

All this, says Simon Derrick, a senior currencies analyst at the bank in London, is “an ominous sign.” The euro, he says, is “living on borrowed time.”

So, what could make these two markets reconnect, and send the cartoon currency plunging into a cloud of dust? The main potential trigger comes from European banks.

This week, the European Central Bank is scheduled to end one of its funding programs–an “absurd” decision, according to Spanish banks. The expiry of this program may well go fine, as the ECB is not likely to stand back and allow a full-blown credit crunch to take hold. Still, any fresh flare-up in interbank funding markets could easily grate nerves over European banks as a whole and hit the currency.

Another trigger could be that most hard-to-pin-down of things: a dose of heebeejeebies. If the markets get spooked for any reason–fears of a Chinese slowdown, poor U.S. economic data, you name it– the dollar could shoot back into favor, because of its status as a supposed safe haven.

The markets are already showing some of that Tuesday. Other key safe havens–the yen and the Swiss franc–are climbing. The buck is also on the up against riskier currencies like the Australian dollar. U.S. government bonds are shooting higher as investors seek safety. Risk nerves are also hitting sterling.

And yes, the euro is under pressure, sinking to just under $1.22 against the dollar as U.S. trading progressed.

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